Include Employer-Paid Premiums for Income Replacement Insurance in Employees’ Taxable Income
CBO periodically issues a compendium of policy options (called Options for Reducing the Deficit) covering a broad range of issues, as well as separate reports that include options for changing federal tax and spending policies in particular areas. This option appears in one of those publications. The options are derived from many sources and reflect a range of possibilities. For each option, CBO presents an estimate of its effects on the budget but makes no recommendations. Inclusion or exclusion of any particular option does not imply an endorsement or rejection by CBO.
|Billions of Dollars||2019||2020||2021||2022||2023||2024||2025||2026||2027||2028||2019-
|Change in Revenues||19.2||34.9||34.4||33.8||33.1||34.1||35.2||36.4||39.8||40.9||155.4||341.9|
Source: Staff of the Joint Committee on Taxation.
This option would take effect in January 2019.
To the extent that the option would affect Social Security payroll taxes, a portion of the revenues would be off-budget. In addition, the option would increase outlays for Social Security by a small amount. The estimates do not include those effects on outlays.
Benefits that replace income for the unemployed, injured, or disabled are currently subject to different tax treatments. Whereas unemployment benefits are fully taxable, benefits paid through workers' compensation programs (for work-related injuries or illnesses) are tax-exempt. (The taxes and premiums that employers pay for those types of benefits are deductible and are not included in employees' taxable income.)Disability benefits (for non-work-related injuries) may be taxable, depending on who paid the premiums for the disability insurance. If the employer paid the premiums, the benefits are taxable (although the recipient's tax liability can be partly offset by special income tax credits for the elderly or disabled). If the employee paid the premiums out of after-tax income, the benefits are generally not taxable.
One broadly available form of income replacement insurance is unemployment insurance. In 2017, the taxes that employers paid under the Federal Unemployment Tax Act and to various state unemployment programs totaled $46 billion. However, there is no comprehensive information on the premiums and taxes for or the value of programs that provide insurance against lost wages and salaries because those programs are structured in various ways. The overall value of that insurance is expected to be a small fraction of the amount of covered wages and salaries. In the Congressional Budget Office's projections, total wages and salaries grow by an average of 4 percent each year over the next 10 years, from $8 trillion in 2017 to $13 trillion in 2028.
This option would gradually eliminate any tax on income replacement benefits over a five-year period but would immediately include in employees' taxable income the value of several taxes, insurance premiums, and other contributions paid by employers. Specifically, all of the following would be subject to the individual income tax and the payroll taxes for Social Security and Medicare: the taxes that employers pay under the Federal Unemployment Tax Act and to various state unemployment programs, 50 percent of the premiums that employers pay for workers' compensation (excluding the portion covering medical expenses), and the portion of insurance premiums or contributions to pension plans that employers pay to fund disability benefits.
Effects on the Budget
This option would increase revenues by $342 billion over the 2019-2028 period, the staff of the Joint Committee on Taxation estimates. The revenue effect falls between 2020 and 2023 as the tax on income replacement benefits is phased out. Over the long term, gains in revenues would result almost entirely from the inclusion of workers' compensation premiums in employees' taxable income. The slightly higher estimated revenues in 2027 and 2028 reflect, in part, the expiration of lower individual income tax rates.
This option would increase employees' taxable earnings and therefore the wage base from which Social Security benefits are calculated. That change, in turn, would increase federal spending for Social Security. Between 2019 and 2028, that increase would be slight. However, it would grow after 2028 as more people whose premiums were taxed retired and began collecting Social Security benefits. The estimates shown above do not include the effects of such increased federal spending on outlays.
The estimate for this option is uncertain because there is uncertainty about the total size of the programs that provide income replacement benefits. The estimate also depends on CBO's projections of wages and salaries under current law. Those projections are inherently uncertain. The estimate further relies on projections of individuals' choices about accepting available work and responses to the change in the taxation of income replacement insurance, which are likewise uncertain.
An advantage of this option is that it would eliminate many of the disparities that currently exist in the tax treatment of different kinds of income replacement insurance. For example, people who are unable to work because of an injury would not be taxed differently on the basis of whether their injury was related to their most recent job or a previous one. Another advantage of the option is that it would spread the tax burden among all workers covered by such insurance rather than placing the burden solely on beneficiaries, as is presently the case with unemployment insurance and employer-paid disability insurance. The effect on covered workers would be relatively small: Their after-tax earnings would fall, on average, by less than one-half of one percent. However, the effect would be greatest among low-wage workers, some of whom might work fewer hours or be less likely to seek work as a result.
A disadvantage of the option is that it would discourage unemployed individuals from accepting available work because, if unemployment benefits were no longer taxable, their disposable income would be higher while they were unemployed than is the case under current law. Research shows that higher after-tax unemployment benefits tend to lengthen periods of unemployment, particularly among those who have no savings and cannot obtain loans after they lose their job. (However, the increase in disposable income would also allow unemployed people more time to find a job that best matched their skill set.)
Another argument against the option is that it would not eliminate all disparities in how income replacement benefits are treated. For example, the income-replacement portion of adjudicated awards and out-of-court settlements for injuries not related to work and not covered by insurance would remain entirely exempt from taxation. Likewise, the extended unemployment benefits that the federal government sometimes provides during economic downturns would never be taxed, because no amount corresponding to an employer's contribution would ever have been included in the recipients' taxable income.